Published by Bob Ciura on July 21st, 2017
In the stock market, reaching for high yields often backfires.
To be sure, stocks with extremely high dividend yields look great on the surface.
For example, Capitala Finance Corp. (CPTA) has a 10% dividend yield. Capitala is one of 405 stocks with a 5%+ dividend yield. You can see the full list of established 5%+ yielding stocks here.
Not only that, but Capitala (like many Business Development Companies, or BDCs) pays its dividend each month. This allows investors to compound their wealth even faster than a stock that pays a quarterly or semi-annual dividend.
Not only that, but Harvest pays its dividend each month, rather than each quarter like most companies. You can see the entire list of all 34 monthly dividend stocks here.
At first, such a high dividend yield looks like a no-brainer. Who wouldn’t want to earn a double-digit return just from dividends?
But looking closer, there are potential pitfalls when it comes to these extreme high-yielders.
This article will discuss why Capitala’s dividend yield—while very enticing—is better left for only the most risk-tolerant investors.
Capitala is a Business Development Company. Its strategy is to place debt and equity investments in low-and-middle market companies.
Capitala typically invests $5 million-$50 million per transaction. It focuses on companies with greater than $4.5 million of annual earnings before interest, taxes, depreciation, and amortization (EBITDA).
The company has a portfolio worth $532.5 million, excluding cash. At the end of 2016, there were 53 investments in the portfolio.
The investment portfolio is highly diversified, across many industry groups and asset classes. More than half of the portfolio is comprised of first lien debt.
Source: Q1 Investor Presentation, page 8
Approximately 81% of the portfolio consists of debt investments, with 19% equity investments.
2016 was a strong year for Capitala. Net investment income, defined as total investment income less expenses, rose 15% to $29 million for the year.
Growth was due to a 6.7% increase in investment income, as well as cost controls. The company saw particularly strong dividend growth of 33% for the year, indicating very good performance from its equity investments.
On a per-share basis, net investment rose 10% last year, to $1.84 per share. This was more than sufficient to cover the dividend payments in 2016.
Capitala’s has two key catalysts for future investment income growth. The first is to invest more money, which will generate higher income.
The company regularly puts new money to work. For example, it originated $21.7 million of investments last quarter. Consistent with its long-term strategy, first lien debt represented 85% of investment activity during the quarter.
The second catalyst is to earn more on its investments, although the company already earns a very high portfolio yield.
Capitala’s total debt has an average yield of 13.2%. Its debt yields stand at the top of its peer group.
Source: Q1 Investor Presentation, page 7
The company has generated strong portfolio returns over the past several years.
For example, from 2013 through the first quarter of 2017, Capitala generated EBITDA growth of 14% compounded annually.
Going forward, the company could benefit from higher interest rates, since the vast majority of its investment portfolio is comprised of debt.
However, the company’s performance slipped in the first quarter.
Total investment income was $14.8 million for the first quarter of 2017, down 15% from $17.4 million in the same quarter last year.
Total investment income missed analyst expectations by a wide margin. The consensus forecast was for approximately $16.06 million.
The major reasons for the decline were a $1.8 million decline in interest, fee, and other income, as well as $0.8 million less dividend income over the first quarter of 2017.
Some of the declines were due to the recently-wound Capitala Senior Liquid Loan Fund. These declines were partially offset by a 14% year over year decline in total expenses.
Overall, net investment income for the first quarter came to $0.39 per share, down 17% year over year. Net investment income per share matched the company’s dividend for the first quarter.
The 100% payout ratio should be a concern for investors going forward. There is no wiggle room for the dividend, which calls into question the sustainability of Capitala’s hefty dividend payout, if business conditions continue to deteriorate.
Capitala has a current dividend monthly payout of $0.13 per share. On an annualized basis, the dividend payout is $1.56 per share.
Based on its current stock price, Capitala has a dividend yield of 11.8%. It has covered its dividend with investment income for seven consecutive quarters.
Source: Q1 Investor Presentation, page 4
However, the dividend coverage has steadily eroded over the past several quarters. Going forward, the company cannot suffer a further deterioration in net investment income from the first-quarter result.
If net investment income continues to decline, the dividend will be at risk.
The dividend coverage is sufficient for now, and Capitala’s near-term debt maturities are modest. Capitala has just $68 million in total debt maturities through 2020.
However, the long-term is less certain. Maturities will spike to $175.1 million in 2021. This will be a challenge, as this represents more than six years of net investment income.
As a result, Capitala may not be a good stock for investors interested in long-term dividend growth.
Stocks with 10%+ dividend yields look great on paper. But with such high yields, often comes high risks. With a 100% dividend payout ratio, Capitala has very little margin for error.
Investors looking for steady, more reliable income would be wise to steer clear of high-yield BDCs. Instead, keep focus on the tried-and-true dividend stocks, such as the Dividend Aristocrats.
The Dividend Aristocrats are members of the S&P 500 Index, with 25+ consecutive years of dividend growth. You can see all 51 Dividend Aristocrats here.
You won’t find any Dividend Aristocrats with 10% yields, but in return, the Dividend Aristocrats offer sustainable payouts and long track records of annual dividend increases.
Capitala has a much shorter dividend history, and a very high payout ratio. It may be able to sustain its dividend going forward, but the level of risk may not be appropriate for all investors.